With Flipping Profits Down, Consider These 4 Alternative REI Strategies

Overall, home flips dropped 12.9 percent during the third quarter of 2019, according to the latest report on fix and flips from ATTOM Data Solutions. Among other trends, data show seasonal slowing in this sector, in addition to reported near-seven-year-low returns.

And as most home flippers can tell you, profits are down. Recognizing and preparing for this less profitable phase in the fix and flip market are the best ways to protect yourself. Keep reading and we’ll talk more about the latest report, what it means for you, and what your options are.

Home-Flipping Profits May Be Down… But Here’s What Investors REALLY Need to Know

When reading this year’s “Home Flipping Report,” many are focused on the slump in actual flips. To be sure, the number of single family homes and condos purchased and sold within one year were down from the second quarter of 2019. However, that appears to be an annual phenomenon. And they were actually up slightly year over year.

What I found most significant was that home-flipping return on investment (ROI) has hit its second lowest point since 2011. The lowest point was in the first quarter of this year. Housing costs are up and the inventory of distressed properties continues to shrink, with foreclosures down 6 percent year over year.

Of those, “zombie properties” (abandoned pre-foreclosure properties) now account for less than 3 percent of the country’s inventory.

More Information From the Report

The report by ATTOM Data Solutions is compiled from sales deed data. It calculates the difference between the purchase price and sales price of single family homes and condos bought and sold in less than 12 months (gross ROI).

The report indicates their analysis of sales deed data found ROI slightly over 40 percent. However, the data available only includes purchase and sale prices. For the purposes of this report, ROI (their “average gross flipping profit”) is the difference between the purchase price and the flipped price.

This report does not factor in rehab costs and other expenses incurred. According to flipping veterans, they estimate such costs typically run between 20 to 33 percent of the property’s after repair value (ARV). This means that net returns for veteran flippers were actually significantly lower than the stated 40 percent.

Other Important Housing Data From ATTOM

If you don’t have time to read ATTOM’s report, here are some other important highlights:

Distressed sales as a share of all transactions drop to the lowest point in nearly 13 years.
Total distressed sales—bank-owned (REO) sales, third-party foreclosure auction sales, and short sales—accounted for 10.5% of all single family and condo sales in Q3 2019. This is down from 11.3% in the previous quarter and from 11.6% from the same time last year.
Distressed sales as a portion of all sales now stands at its lowest point since the fourth quarter of 2006.
Higher home prices have a slower turnaround time.
Home prices rose across the country by 9% year over year in the fourth quarter of 2019. This means the typical home remains a financial stretch for most average wage earners.
Even as mortgage rates remain low, the shortage of affordable housing puts a downward pressure on sales.

While Flipping Profits May Be Down, You Still Have Options

With a shrinking inventory of distressed properties, if you are an investor with a home-flipping business model, it would be wise to adjust now. While the acquisition and rehab costs are escalating, a change in strategy and timing can significantly reduce the taxes you pay on this activity.

In his ultimate guide to flipping, Brandon Turner acknowledged that, “[Flipping profits] are not all yours to keep. Instead, any profit you make needs to be shared with the government when tax time comes. House flipping is generally considered ‘active’ income and therefore taxed at the highest levels.”

Flipping is taxed at the highest rates, corresponding to ordinary income tax brackets. This can be reduced to the capital gains tax rate while still allowing you to benefit from the upside potential of distressed properties. Keep reading below for more about this and a list of other potential options you can use.

1. Hold onto the property for 1 year and 1 day, and change your intent.

As you likely know, capital gains are the profits from the sale of an asset (like a home or property). Such profits are considered taxable income.

When you sell your property in less than a year, you are subject to capital gains tax (short-term capital gain) that is based on ordinary income tax brackets, which can be quite high. However, if you hold onto your property for at least one year and one day, you will pay a much lower capital gains tax rate (long-term capital gain)—as long as you can also demonstrate that it was your intent to hold the property for productive investment use (similar to a 1031 exchange).

Some quick facts about capital gains tax:

Capital gains tax is assessed on the positive difference between the original purchase price and the sale price.
When you take the total of the capital gains then subtract any capital losses, that is known as the net capital gains.
Long-term capital gains tax rates can be either 0%, 15%, or 20%.
Short-term capital gains tax rates can go as high as 37%, since they are based on your ordinary income tax bracket.

2. Consider live-in flipping for a couple of years.

Living in the home you’re flipping can arguably be difficult. Usually, there is a lot of construction going on, and it can be tough to keep things organized. Mindy Jensen’s article addresses exactly that.

But Mindy and many other investors—myself included—have figured out that this a great way to avoid paying taxes on their flips through the Taxpayer Relief Act passed in 1997. All you have to do is own the home and live there (it must be your primary residence) for two of the five years preceding the sale.

If you can live in your property for two years while you’re flipping it, you can then write off up to $500,000 in capital gains ($250,000 for single folks).

3. Change to the BRRRR method.

Brandon Turner first coined the term BRRRR some years back, and it’s been popular ever since. If you’re unfamiliar, the BRRRR method describes the process of Buy, Rehab, Rent, Refinance, and Repeat.

It involves:

Buying a property: Specifically, one that you intend to hold—not flip.
Rehabbing the property: You have to make it livable and functional while also adding value.
Renting the property out.
Refinancing the property: Try to look for a bank that will offer cash out instead of paying off debt. Also, you need to borrow on the appraised value. So, look for a bank that is prepared to lend on the appraised value as soon as a property has been rehabilitated and rented out.
Repeating this process again for a steady stream of cash flow.

4. Use 1031 exchanges to defer taxes on sales.

Instead of looking to flip a house quickly, you can hold onto it and increase your buying power with a 1031 exchange. With a 1031 exchange, you follow certain steps to defer paying any capital gains tax when selling one rehabilitated house to purchase more investment properties.

When using a 1031 exchange, you must have had the intention of holding the property for productive use at the time of your purchase—although the rules and regulations do allow for a change of intent after purchase when necessary.

Renting out your rehab property for a period of time in order to take advantage of a 1031 exchange is a great idea and definitely one that you should consider.

Bottom Line: Learn How to Adapt to Remain Profitable

If you are an investor who has been flipping homes for profit, the diminishing returns may have you worried. However, you have options.

You can change your business model just a bit and adjust your activity. This can help you reduce your tax burden and maximize your profit.

As Ashley Wilson cautioned in her recent article: “As deals become more scarce, it is more important than ever to continue learning from our past so that we are still in business in the future!”

Are you a fix and flipper? Does data included in this report concern you?

Weigh in with a comment below.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.